Taxation of Swaps

How many Elite Traders are trading swaps these days? Or instruments like ETFs or options on ETFs that include swap contracts? How many are interested in swap futures coming from CME soon? Here's our new draft blog article on tax treatment for swaps. Any one have questions on tax treatment for swaps?

A growing trend for traders is to get involved with swap transactions. In general, tax treatment for swaps is ordinary gain or loss, but some financial instruments partially including swaps may qualify for lower 60/40 tax rates in Section 1256. The CME Group just announced new futures swaps that should fall in this category.

What exactly is a swap? According to Investopedia âA swap is an agreement between two parties to exchange sequences of cash flows for a set period of time.â Classic swaps involve bonds and/or currencies, swapping interest rate and currency cash flows. For example, a global business often uses swap transactions to cushion risk exposure outside their main business activities. Derivatives are meant to smooth balance sheets, but in 2008 they contributed to the banking and markets crisis.

Hedge funds often take one side of a swap transaction with corporations and banks. Retail traders rarely have that type of access to the swaps marketplace. But, theyâre gaining exposure to a bevy of new exchange-traded derivative products, including options on swaps, and ETFs consisting partially of swaps. All of these choices are great, but they muddy the waters on tax treatment.

As we pointed out in our blog about the Dodd-Frank Financial Regulation bill enacted in July 2010 http://www.greencompany.com/blog/index.php?postid=86, Congress reined in the privately traded swaps marketplace requiring certain derivative transactions to be cleared on futures exchanges, with posting of collateral and compliance oversight. Congress and the IRS specifically addressed taxation, stating that although swaps would be cleared on futures exchanges, they still had ordinary gain or loss treatment, not lower Section 1256 60/40 tax rates as many hoped the rule change meant.

Back in March 2011, our blog covered ETF tax and regulatory issues http://www.greencompany.com/blog/index.php?postid=109, including tax treatment for options on ETFs. Since then a few clients have asked us about these instruments, where swaps are a minor or major component of the underlying ETF. We make a case for treating options on broad-based ETFs and options on commodity ETFs as Section 1256 contracts. What happens if that underlying ETF contains a material amount of swap transactions? Does that taint the option from using the more tax-beneficial Section 1256 treatment? Yes, sometimes it does, see more below.